Value at Risk Flashcards
How is risk measured in equity markets?
Standard deviation or beta.
What measures of risk exist in bond markets?
Volatility, duration, convexity.
What measures of risk exist in options markets?
Delta, gamma, theta, etc.
What does VaR measure?
The expected loss from an adverse market movement with a specified confidence level over a particular time period.
How is the probability of loss denoted in VaR?
By the confidence level \alpha
What happens if a bank faces a capital shortfall?
- Banking supervisors scrutinize it.
- Risky business may need to be reduced or shut down.
- Its banking license could be revoked.
How does Modern Portfolio Theory (MPT) help investors?
It allows investors to assess diversification benefits in a given portfolio.
What does standard deviation measure in MPT?
Uncertainty, not risk.
What are the two main approaches to calculating VaR?
- Historical Simulation Method – Uses past market data to estimate VaR.
- Model-Building Approach – Assumes probability distributions for market returns and calculates VaR analytically.
What is the advantage of the model-building approach?
It allows for analytical calculation without relying on historical data.
What time horizon do regulators usually require for capital charges?
h days with a 99% confidence level.
How is multi-day VaR usually calculated?
By calculating a one-day 99% VaR and then scaling it appropriately.
What type of risk do investors care most about?
Downside risk (likelihood of losses).
Why is standard deviation not the best measure of downside risk?
It equally weights both upside and downside price movements
What are three key advantages of VaR?
- Captures risk in a single number.
- Easy to understand.
- Answers the question: “How bad can things get?”
What is a major limitation of VaR?
It does not account well for fat tails, where extreme losses are more likely than normal distribution predicts.
Why does this limitation matter?
Asset returns often exhibit fat tails, meaning extreme losses are more probable than VaR suggests.
What does CVaR measure?
The severity of losses beyond the VaR threshold.
Why is CVaR useful?
It provides a better understanding of extreme losses compared to standard VaR.
